Too Small to Worry? Hardly!
By Thomas M. Langer, Jr.
Undercar Digest Business Editor
The attorney across the desk said we had three options when my grandfather died:
1. Figure out how much money we owed for the shops, auto inventory and the rest in estate taxes and write a check. It wasn’t happening, there was not enough money.
2. “Borrow” the money from the IRS in the form of a pay plan with all of the interest, penalties and the rest. It is painful and takes a lot of years and interest to seal the program.
3. Close it down, liquidate the assets and call it a day.
If this sounds like fiction, it isn’t. It happened to my family in 1982. My grandfather had contracted cancer and it ravaged him very quickly. No estate planning had been completed.
Shortly after this meeting, we stood watching as all of the business assets, built of many years of risk and toil, sold for basically pennies on a dollar. Many of our family’s good friends were there for the auction. Who could blame them for buying the assets at bargain basement levels? In about five hours a dream, a legacy and a business intended to employee seven kids went away. That’s why you are reading this article today. Please learn from this experience and avoid the same kind of frustration, fear and loss we experienced.
Before we launch off, realize I am not an attorney and am not a tax professional. I’m a car and parts guy just like you. This article is meant to inform and motivate you to action, not provide estate planning or any other legal or tax advice. See your attorney, accountants and banker for all of that help.
Today the picture is a bit different. Now there is the Unified Tax Credit, which will allow $5.45 million in assets to transfer to your family without further taxes at the federal level (the 2016 indexed amount). But before you sit back and relax, keep in mind that 15 states have estate taxes, six have inheritance taxes and two have both.
Moreover, you best have a very accurate picture of what your stuff is worth. There are three ways to value a business and its assets:
1. Your way – the old rose-colored glasses approach that your stuff isn’t worth a lot, and using the notes on a napkin approach, doesn’t come close to the real-estate tax levels and have your kids inherit a tax issue.
2. A real valuation business that takes a more objective approach. Strongly suggest you shell out a few bucks and get one of these outfits to value your shop ASAP. Do keep in mind you are almost always better off getting someone who has experience doing shops. Do get references from other shops. Another good option may be your own accounting outfit.
3. The IRS way. In the absence of a well-done valuation, you may receive the IRS valuation. As you may suspect, that may well be higher than either of the other two options.
When you consider your stuff, you must look at:
• Real estate
• Life insurance amounts (the amount that will be paid out –many forget this – and it may easily push you over the top)
• Equipment
• Vehicle inventory if any
The bottom line is that many businesses can quickly start sniffing around the $5.45 million amount. You may be VERY surprised. Skip this and you may end up just like we did once upon a time. Just an FYI. The federal estate tax maximum level is a whopping 40%. So, let’s say your estate is worth $7 million; you will be taxed on the $1.55 million over the Unified Tax Credit level. Your family could see a bill for $620,000, due immediately. Unless your family has an extra $620,000 in the checking account, read on.
Incidentally, there is one assumption that may or may not be true that many make in terms of their estate. It is true that you may pass all you want to your spouse without any federal (there may be state liability) tax liability. As a result, if I had an estate worth $10 million, I could pass it all to my wife, assuming she dies after me, without penalty. It is at the death of the second spouse where all of the tax issues break loose.
As a result, assuming my spouse dies sometime later and leaves $10 million to our kids/heirs, they may end up owing 40% of the difference between that and the $5.45 million, or $1.82 million. Many people with the best intentions buy life insurance to cover this shortfall. Keep in mind that unless your attorney and life-insurance agent work together in the drafting of the beneficiary statement, you may simply make your tax issue bigger by heaping the insurance proceeds on top of the $10 million.
So, what is the answer? Here are some thoughts as a place to begin kicking this around:
• Assuming you have a child/heir who wants the business, and you want to have them take over in the event of your death, life insurance that is set up properly could address the tax shortfall.
• If you do not have a child/heir to take over the business, then valuation is equally important since there may be cost basis items that could lower the gains in the end.
• You could simply plan to live forever and not get sick! (FYI, we all come with an expiration date.)
We’ll take a moment to look at each of these options:
Assuming you wish to pass along the business, there may be real considerations regarding other children and the impact of this arrangement on them.
Moreover, someone is going to pay taxes somewhere. If you simply hand the business over while still alive to your child, there may well be gift and/or capital gain taxes. On the other hand, if you establish some sort of installment plan, there will be interest and possibly taxes. There are other considerations, but these are a few of the major issues.
Providing the equitable distribution of assets at your death, or that of a subsequent spouse, is generally important to make peace among the remaining children. One time I was asked by a client to stop by his home to talk with him and his spouse. They related the following story.
“We were so pleased we were passing along the shop to our son. He has been working with us for over 15 years and knows the business very well. The past few years we have been able to get away without worrying about the shop, either location. And none of our other kids were interested in the shops at all. It seemed like we were all set.
“After we made the announcement at Thanksgiving as something we were thankful for, you could have cut the air with a knife. It seemed like the only people happy at that meal were the two of us and our son. Everyone else was visibly upset.
“Some weeks later one of our kids shared the problem. Seems that the kids were upset that they were being cut out of the family business. What it really amounted to was that they saw the amazing deal we made with our son with them losing their share of the estate down the road. It was amazing. Something we never even considered.”
Obviously the first issue here is that the shop owner needed some guidance regarding how to avoid this situation. When he went back to the attorney, it was decided they would get a life insurance policy with the non-owner kids as beneficiaries in order to get their “share” of the estate value. Off to an agent he went.
Think back to what we discussed just a few moments ago. Just when the business owner thought he had saved some estate issues by selling the business while he was still alive, he could have compounded his own estate-tax issues by adding a large chunk of insurance. Fortunately, the attorney and the life-insurance pro structured appropriate trusts to handle the proceeds.
The lessons in this story are summarized in three bullet points:
• Any financial-estate move you make may seem brilliant, but be sure you aren’t inadvertently cutting other family members out of the scene.
• Get some assistance in the conversation relative to making your great announcement about a child taking over the business. A few dollars spent talking to an appropriate therapist or others experienced in this process may be a very good investment.
• Nothing in estate planning may be taken for granted. Typically, successful small business owners need to spend many hours in planning along with the appropriate professionals. Estate planning is a minefield of unintended consequences.
Selling to a key employee or another shop owner is almost simpler than transferring your shop to a family member. In this case any payment becomes part of your estate, which means you need to do some forward planning here as well.
If your plan is not to die or ever get sick (said “tongue-in-cheek”), I have but one word: REALLY?
The bottom line to estate planning for shop owners is that you need to begin while your health is holding up, your plans are coming together and business is moving along. Wait too long and there’s a great chance you’ll run out of time, money or a business worth selling. Learn from our family’s personal experience, and don’t simply pass the problem on to your spouse and kids.
Thomas M. Langer Jr. has a career spanning a lifetime in the industry and is combining this experience with new information to provide readers of Undercar Digest with information you need to build a better business!